Using the IRM to Help Taxpayers During Audits Exploring a Taxpayer’s Unreported Income

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Today we welcome first time guest poster David Breen, the Acting Director of Villanova’s Federal Tax Clinic, former Senior Counsel with the IRS Office of Chief Counsel in Philadelphia and longtime adjunct faculty member in Villanova’s Graduate Tax Program. In addition to his Counsel experience, Dave began his career with Exam. He has taught courses in Villanova’s graduate tax program for years, including Tax Procedure and our innovative trial litigation simulation course. While Keith has been visiting at Harvard, Dave has ably directed our tax clinic. In today’s guest post, he discusses some of the IRS’s own rules relating to examinations that focus on unreported income as well as some of the powers practitioners can but rarely do exercise in the context of those examinations. Les

The country is approaching the half way point of the NFL season and during the Eagles games I’ve watched so far, I can’t help but again notice the tendency of coaches to cover their mouths while talking to one another. This practice, which dates back to at least 2000, prevents opposing teams from employing lip readers to intercept the play the opposition is calling. Stealing plays in a game? By professional lip readers? Really? A bit of overkill, don’t you think? But football is not alone in this type of larceny. Less than one month into this year’s baseball season, the Padres were accused of positioning a spy inside the scoreboard with binoculars to telegraph pitches to San Diego batters.

This got me to thinking about the lengths that professional athletes will go to increase ever so slightly an edge over their opponents. And with that in mind, it made me look to my own profession as a tax attorney for whatever edge, legally, of course, that I could exploit as well. I didn’t have to look far.


When I was an IRS Revenue Agent back in the 1970s, the Internal Revenue Manual was IRS’s playbook, containing well-guarded tips, resources, recommendations, and directions on how to audit taxpayers. As a Senior Counsel in IRS’s Office of Chief Counsel from 1987 to my retirement in 2014, Part 35 of the IRM, also called the CCDM, provided the same practical guidance and advice for IRS attorneys. Today the IRM continues to guide IRS employees in the performance of their duties and thanks to the Freedom of Information Act (FOIA) it can be an invaluable resource for practitioners as well. In my experience, however, I find that many practitioners fail to avail themselves of this resource. In other words, they don’t take advantage of the ability to read IRS’s lips from across the gridiron to see what IRS’s next step will be.

When it comes to an IRS audit, particularly in the SBSE division which includes self-employed Schedule C filers, unreported income is the name of the game. From 2008 – 2010 the average annual tax gap was $458 billion, up from $450 billion in 2006. IRS revenue agents are given discretion in deciding which deductions to scrutinize on a return. Proof for deductions that are LUQ (large, unusual, or questionable) is sure to be requested. Examiners do not, however, have discretion in examining gross income. Unlike deductions, gross income must be examined in all audits. It is one of the relatively few mandatory items examiners must investigate.

This article discusses how a practitioner can utilize the IRM to represent clients more competently during an audit of gross income. I am limiting my comments to IRM Part 4 – Examining Process, but the advantages of being well-versed in IRS’s own procedures applies well beyond this area.

The law is clear on gross income: all income from any source is taxable unless specifically excluded somewhere in the Code. Taxpayers are required to maintain books and records to support items on their returns. If a taxpayer refuses to provide books and records, IRS may issue a summons to the taxpayer and third parties to compel production of documents and to give testimony under oath. Finally, before an examiner may use financial status or economic reality examination techniques to determine the existence of unreported income there must be an indication that there is a likelihood of unreported income.

While the above paragraph would score well on a law school tax final, it provides little insight into how the law is put into action. Let’s put some flesh on the bones by looking at how examiners are taught to audit returns.

To insure that returns are examined within the 3 year statute of limitations, IRM requires that the examination and disposition of individual income tax returns be completed within 26 months after the due date of the return or the date filed, whichever is later. For example, if an examiner is assigned a timely filed 2015 return, the audit should not be started if it cannot be completed by June 2018 (26 months from April 15, 2016). This includes, however, the time to process the return, select it for examination, ship it to the examination group closest to the taxpayer’s location, assign it to an examiner, and schedule an appointment. To add additional incentive to IRS to examine returns promptly, interest is suspended if the Service fails to notify the taxpayer of a liability within 36 months of the later of the date the return is filed, or the due date for the return without regard to extensions. Like soggy hors d’oeuvres once the main course is served, returns falling short of this timeframe are forgotten about, “surveyed” as excess inventory and replaced by fresher, more current work. The lesson here is that despite the three year statute of limitations on assessment of tax, the likelihood of a return being audited is actually much less than three years after its filing under the 26 month cycle rule.

For those returns that are audited, however, examiners are given specific guidelines for verifying gross income. How does an IRS examiner decide how detailed the gross income investigation must be? To answer, we have to consider one more Code section, IRC § 7602(e), enacted as part of the IRS Structuring and Reform Act of 1998:

(e)Limitation on examination on unreported income

The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

Prior to the enactment of IRC § 7602(e) examiners could (and often did) investigate gross income by engaging in intrusive inquiries into a taxpayer’s private life and finances. Interviews of business associates, co-workers, lenders, and even neighbors were conducted, sometimes without the taxpayer’s knowledge. Time consuming, intensive, expensive requests for voluminous records were the norm rather than the exception.

IRC § 7602(e) put the brakes on IRS examiners. Before an examiner may conduct an in-depth, intrusive examination – what the statute refers to as financial status or economic reality techniques – the examiner must first have some reason to suspect that a taxpayer has not reported all gross income. So called “indirect methods” are economic reality techniques. How does an IRS agent determine if there is a likelihood of unreported income to gain entrée into a detailed investigation? The answer is in the IRM.

IRM 4.10.4 sets forth a number of mandatory “minimum income probes” examiners must perform. If the minimum income probes indicate a likelihood of unreported income, the examiner must consult with a group manager. They jointly determine whether to conduct a more in-depth examination of income and document their findings in the workpapers. This more in-depth examination may include, but is not limited to a bank deposits and cash expenditures analysis, a source and application of funds analysis, or a net worth analysis – what IRS calls a formal indirect method of proof. ( Note, however, that IRC § 446(b) allows IRS to use any reasonable method. The high water mark of reasonable may have been IRS’s Atlantic City Tip Income Project back in the 1980s when IRS reconstructed cocktail waitress tip income by placing undercover special agents in casinos to watch how much tip income waitresses typically received during a shift and applying those findings to compute tip income for a “normal waitress.”).

All practitioners want to dissuade examiners from conducting time-consuming, costly, detailed indirect methods. Volumes have been written on defending a client when IRS determines under one of these methods that a taxpayer hasn’t reported all income. But remember, the minimum income probes are the gateway to the use of a formal indirect method of proof. For that reason, they should be the first line of defense in representing clients.

What are these “MIPs”? It depends on the type of taxpayer. The minimum income probes for individual business returns, i.e. Schedule C taxpayers, include: preparing a financial status analysis; conducting an interview with the taxpayer or representative; touring the business; evaluating internal controls; reconciling the income per return to the taxpayer’s books and records; testing gross receipts by tying original source documents to the books; preparing an analysis of the taxpayer’s personal and business bank and financial accounts; preparing an analysis of business ratios; and determining if there is Internet use and e-commerce income activity.

I present two ways for the minimum income probes to be used proactively by representatives.

  1. Lay the groundwork during return preparation. Most return preparers send some form of tax organizer to clients which clients complete (or at least are supposed to complete) as part of having their returns filed. I encourage preparers to include questions concerning the minimum income probes in their client surveys. Gathering information on internal controls, bank accounts, business ratios, and e-commerce activity will serve as reminders to clients on what they records they should be keeping and also identify potential weak areas in the client’s operations. Weaknesses that can be corrected or anticipated in the event of an audit.
  2. Challenge the examiner’s conclusions regarding the use of an indirect method. If early in the audit, say after the initial meeting and taxpayer interview, an examiner issues a detailed, voluminous information document request (IDR) clearly focused on income or personal living expenses, that is a clear indication that the examiner is “ramping up” the examination of gross income. Representatives should not simply shrug and hope for the best. I encourage representatives to ask the examiner in writing, if the examination has extended into IRC § 7602(e) territory. If the examiner answers affirmatively, or doesn’t answer at all, the representative should take the offensive and request a meeting with the group manager, request the examiner’s workpapers detailing the minimum income probe analysis and the discussion with the group manager green-lighting the indirect method, file a FOIA request for the workpapers, or all of the above. A taxpayer should be given an opportunity to respond to an examiner’s determination that the minimum income probes reflect unreported income. If the agent’s analysis is flawed, it is better for IRS and your client to not waste time on needless issues. To date, however, I have yet to find a representative who has taken any of these pre-emptive steps. My suspicions were confirmed when my opinion search of 7602(e) on the Tax Court’s website produced a single case which dealt only with the effective date of the statute.

In summary, as a representative you should adhere to the old adage, “Forewarned is forearmed” and study the IRM as if it were the Cowboys playbook and you were the coach of the New York Giants.


  1. This article was quite useful and will improve my practice. Thank you for sharing your experience & expertise. I need to reacquaint myself with the IRM, it’s been awhile since I went through it in a comprehensive manner. Do you recommend other sources for similar tidbits of exactly how to apply various portions of the IRM in the event of an audit?

  2. David,
    Many thanks for a well written piece with a phenomenal punch line.

  3. Henry A. Jefferson, Esq. says

    Great article!

  4. Bob Kamman says

    Why should practitioners be familiar with what is in the Manual when IRS employees aren’t concerned about it? Well, yes, you’re right, it’s our job to teach them since the training and supervision they receive are obviously inadequate. From today’s TIGTA report:

    “Throughout an examination, examiners are expected to follow Internal Revenue Manual procedures to consider the taxpayer’s ability to pay a potential assessment. . . .
    “In Fiscal Year 2015, 50 percent of all Field Collection closures and 19 percent of all Automated Collection System closures of taxpayer delinquent accounts resulting from an examination were closed currently not collectible. This audit was initiated to determine whether the Small Business/Self-Employed Division Examination function is properly and accurately performing collectibility determinations before and during Field and Office examinations.
    “Examiners did not follow collectibility procedures in 62 (56 percent) of 110 sampled cases, which involved 101 separate instances in which procedures were not followed. Specifically, examiners did not always consider collectibility, document their collectibility evaluations, or discuss collectibility issues with their managers. Additionally, examiners did not always contact the Collection function when Examination function procedures required them to do so, refer required cases to the Collection function, or complete financial information needed to assist in future collection efforts. TIGTA estimates there were 1,731 Office examination cases and 1,445 Field examination cases in which employees did not follow established collectibility procedures and the case was later worked and closed by the Collection function as currently not collectible—with the IRS having received no taxpayer payments.”

    Question: The penultimate paragraph refers to a FOIA request. Wouldn’t this be a Privacy Act request?

  5. michael j knight says

    dave code sec 7602 (e) was the code section i got enacted when i chaired the aicpa small business taxation committee, when the irs used their financial status audit techniques ab initio, that is at the start of the exam.

    it was a fight but well worth the effort. it should be used for the structuring issues now at the forefront of aggressive irs tactics.

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